Figure 1:2 shows the impact of the cost of occupancy. In this case it illustrates commercial space which is 100% physically occupied, but is only 58.4% economically occupied each year of the lease.

ASSUMPTIONS:

• Size: 5,000 square feet
• Rent: $1.25 per square foot ($6,250 per month)
• Lease term: three years (total lease rent $225,000)
• Concession: one month’s rent ($6,250)
• Tenant improvements: $15 per square foot ($75,000)
• Leasing commission: average 5.5% over the life of the lease
• No deduction for vacant days (no income)
• No adjustment for a declining market with lower rents
• No deduction for marketing costs (e.g. advertising, flyers, personnel, signage, etc.)

As these two examples bear witness, reports of physical occupancy are often misleading. They create a false sense of security, which often leads to poor decisions. When reports of physical occupancy numbers include financial costs, they give useful information. An accurate financial picture of occupancy provides (1) help for a current owner or prospective owner in determining the value of real estate and (2) help for the current owner in evaluating the real estate’s performance.

People who use physical occupancy without costs as a management tool for acquiring or managing real estate are working blind. The consequences of using physical occupancy without costs for management decisions are deteriorating yields and values and, ultimately, failed investments.

The media continue to use physical occupancy as their method of reporting the fiscal state of income property. Unfortunately, the percentage of square feet or units that are occupied is not a reflection of commercial real estate’s financial status. Following the media’s lead, many appraisers, lenders, property managers, asset managers, and owners still regard physical occupancy as a financial barometer of real estate.

Physical occupancy is a percentage relationship of two sets of numbers: (1) total net rented square feet (commercial), or the number of rented units (residential) divided by (2) the total net rentable square feet (commercial), or the total number of units (residential) that are available to rent. This information tells which portion of a building is physically occupied. It does not reveal the costs of occupancy for the real estate. Because real estate investments are capital intensive with thin margins, the asset management process is flawed when it doesn’t include the costs of occupancy.

During strong real estate markets (favorable supply/demand relationship), the costs of occupancy are carried by the lessee. When there is a soft economy, the costs of occupancy increase, and the burden for the costs is born by the lessor. Weak markets make real estate’s cash flow significantly more vulnerable. Today’s weak economy highlights real estate’s thin profit margins, and punctuates the need for accurate information.

The following analogy may put physical occupancy in a better perspective: A computer distributor sold 10% more computers this quarter than in the same quarter last year. However, the current price of the distributor’s computers is 30% less than it was during the same period last year. That price reduction makes a big difference in the overall picture. Without this information, the distributor wouldn’t have a realistic reading of its financial situation. The result would be a false sense of security, which might lead to poor management decisions.

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